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August 28, 2011

BEIJING - China is flabbergasted by the inability of the United States and Europe to take tough political decisions over their economies, especially since the current malaise has a huge bearing on its own regional strategic decisions.

With its coffers filled with US$3.2 trillion, China is at once America's largest single creditor, number two economy in the world, and sitting on over 40% of global monetary reserves. So, even moving small amounts of its treasure around - to the US dollar, euro, or some other currency - could affect many financial balances that the global stock market crash and volatility have already rendered precariously placed.

Today, about 70% of China's reserves are in dollars, 20% in euros and the rest is divided among other currencies. The recent

appreciation of the Japanese yen against other currencies seems to owe to Beijing's decision to start diversifying its reserves.

Beijing is worried and puzzled by the apparent difficulties that America and Europe face in governing their economies. The recent crisis was likely due to vast quantity of hedge funds moving around looking for high returns that are no longer available, as Spengler wrote (see End of the road for hedge funds Asia Times Online, August 9, 2011). This in turn means that some financial institutions have not yet woken up to the fact that after the 2008 financial shock those magical derivatives' yields are now no longer possible.

Famed American economist Nouriel Roubini believes this is a crisis of the capitalist system and writes:
A financial and economic crisis caused by too much private-sector debt and leverage led to a massive re-leveraging of the public sector in order to prevent Great Depression 2.0.

But the subsequent recovery has been anemic and sub-par in most advanced economies given painful deleveraging. Now a combination of high oil and commodity prices, turmoil in the Middle East, Japan's earthquake and tsunami, the eurozone debt crises, and America's fiscal problems (and now its rating downgrade) have led to a massive increase in risk aversion. (Project Syndicate, August 15, Is Capitalism Doomed?)
However, anti-capitalist and communist China does not draw the same conclusions. All of this was not a surprise, it had been there for months. The knife fight between Republicans and Democrats, which ended in a last minute compromise, could have been reached much earlier, without dragging down American credibility. From Beijing it looked as if many politicians just wanted to advance their parties' agendas, even at the cost of sacrificing the public interest and downgrading the US credit rating.

In parallel, the over one year of inertia in Europe to agree on a solution to the problems in Greece led to the contagion of the crisis and its spread to Italy. The reason for this inaction in Europe is even less clear than that in America. Whether it is due only to the differing agendas of the parties in Germany, or, as some here believe, if there may be a more sinister Franco-German strategy at work - a plan to scuttle the economically misbehaving southern Europe, in order to reward virtuous northern Europe.

Whatever the reasons, politics in the two continents put at risk and devalue about 90% of China's reserves, and, at a moment of deep reflection about Chinese policy, stressed the inefficiency of the Western democracies. They seem incapable of thinking long-term and especially have a hard time taking care of their general interests, and yet they want to tell everyone else how they should rule by exporting some kind of "democracy for dummies” from Libya to Afghanistan. This cools the already lukewarm Chinese enthusiasm for Western democracy.

Because of the quantity of its reserves, it is unthinkable that China would sell all its dollars to buy Indonesian rupiah or Brazilian real - there are no other currencies in the world that can accommodate that amount of money. Furthermore, selling dollars now would accelerate the depreciation of the greenback. Finally, the Chinese yuan has a quasi-fixed exchange ratio with the dollar, and in practice the two economies are enmeshed into each other.
But for Beijing, the absolute centrality of the dollar seems to be near its end. China would like to reform the international financial system, some think of reducing the role of the dollar and instead pushing for the creation of a basket of currencies of which the yuan could be part. This basket would safeguard China against future risks.

Might this reform ever happen? Or will it come in time to stop the impending avalanche? Although it has delayed it, the US Federal Reserve could still launch a new program of "quantitative easing" as economic stimulus. This would increase the flow of speculative funds into China and stoke the flames of inflation here, which in July reached 6.5% despite months of government efforts to lower it.

Beijing thinks that the Fed's maneuver could perhaps alleviate the situation in America, but then any new economic difficulties in China or Asia would fall back on America itself. China would rather see Washington cutting military spending and the welfare state, reforms that just might ease America's financial burden and open new security concerns (with military spending). These ideas would imply crucial discussions with China. But if American Republicans and Democrats cannot agree between themselves, how can Washington agree on an economic and strategic policy with Beijing?

The present crisis then is not so much economics but politics: a lack of government leadership and the inability to find compromises other than at the lowest level, such as the recent ones in America and Europe. It is this weakness of the American and European governments that scared markets in recent weeks.

This lack of clear political direction points to a deeper crisis than that of 2008. Today, China is concerned that the failure of political solutions in America or Europe could give new momentum to protectionist pressures, which in turn could crack the free-market system that has driven the last 20 years of globalization and China's 10%-per-year growth.

If you crack the market system, even global politics could take a new direction. The system of free market exchange was one of the main forces enriching the West while ultimately causing the collapse of the Soviet Union and the overall convergence of countries of the world around the American economic model.

There could be another economic order around the corner after the present market crisis, for which Beijing could begin in the coming months to prepare. Then, if in this climate of global nervousness and confusion, China, the one country that managed to stem the crisis since 2008, also becomes more nervous and possibly aggressive, the overall risks are multiplied. It could be a dangerous game of mirrors and reflections where each country second-guesses the other misperceiving the whole situation and sending the wrong signal to the other. There is nothing more dangerous than the volatile cocktail of economic tension spruced up with military posture.

Is this already happening?

The superstitious are already concerned for the omens. Last week from the northern port of Dalian China launched into the sea its first aircraft carrier for a 15-day tour around its coasts. It was China's major move to shift towards a blue water navy and projecting its forces well beyond its borders.

The vessel is actually an old Soviet carrier, the Varyag, which has been refitted and put back into operation - something almost as difficult as building a new one from scratch.

There are questions concerning when the former Varyag will be fully operational. It is possible that during this first cruise, the navy will attempt to have aircraft land and take off, but it will probably just be helicopters not jets. Training pilots and crews of an aircraft carrier is extremely difficult, and experts estimate that it will take about ten years before it will be fully operational.

However General Liu Yuan, son of former President Liu Shaoqi, said already that one carrier is not enough - he wants three. The numbers actually make sense in tactical terms, as a fleet with aircraft carriers should need at least three: one at sea, one in maintenance, and one in port and ready to intervene.

It is unclear when such a fleet could be available to Beijing, but it would take at least 15 years. With it, China would have fully operational projection into the South China Sea, an area contested in part or in whole by five other countries and territories: Vietnam, the Philippines, Brunei, Malaysia, and Taiwan; and China could probably look even further with missions to control the shipping routes from vital supplies from Africa. Moreover, China would satisfy a dream born in 1929, when Admiral Chen Shaokuan, asked for its first aircraft carrier.

It would be so prestigious. Chinese admirals and generals repeat that even smaller countries such as Thailand have aircraft carriers - what's so strange about China wanting one? However, the strategic outcomes for China may be different from those desired.

In fact, anticipating the relaunch of the Varyag as a Chinese vessel, the Philippines in recent weeks called for two aircraft carriers from America. And certainly Vietnam, if only it could completely overcome Washington's reservations, would not reject the offer of a carrier.

To these requests, some in China smirk ironically: how will the poor Filipinos pay for two expensive aircraft carriers? Of course, the question is even more relevant in times of global economic crisis. But the irony ignores an important strategic consequence of the launch of the Varyag.

The ship is to be followed by spy planes and satellites looking over the world - something that has in fact ignited the fuse of a possible arms race in the Asia-Pacific. From California in the US to the Gulf of Bengal in India, countries now know that along with being a new world economic power, China does not want to remain a military dwarf.

The ambition is legitimate and normal, but strategy does not proceed in a linear fashion.

By itself, China's economic growth in recent years is changing the world's strategic balance.

Furthermore, if on one hand it has driven the growth of other developing countries from India to Africa, on the other it is also raising a lot of problems and new rivalries between old and new players on the global scene.

Chinese exports of industrial goods and imports of raw materials and semi-processed products are creating and destroying fortunes around the world. If these actions combine with Beijing's aspirations for a truly modern military force, fears begin to grow - especially as these concerns are swelled by the opacity of the Chinese political system and its radical difference from Western political systems, dominating the rest of the world.

At a time of general instability, a bogeyman against whom all fears are projected might be quite destabilizing as it shows off an objectively dangerous weapon.

Yet it is not simply a Chinese issue. The recent politicking, bickering and wavering on economics in the United States and Europe, the indecisive intervention in Libya, the confused position in Syria or Yemen that fans the flames of revolt but is short of viable political outcomes, all of this dents Western credibility in China. This occurs on the backdrop of the lingering instability in Iraq or Afghanistan and the growing fragility in Pakistan, all victims of many American wrong decisions a decade ago. America and the West have proved unable to move out of those mistakes.

It is the perceived waning of this credibility that also plays up China's strategic necessity of a carrier, All builds up a very dangerous game of reflections, smoke and fear, something that historically has led to the direst consequences, which now would be the unutterable word since the fall of the Soviet Union: World war.

Francesco Sisci is a columnist for the Italian daily Il Sole 24 Ore and can be reached at fsisci@gmail.com

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